Question

Chapter 5 Summary

Elasticity and Its Application

Create animated video to summarize this chapter.

Answer 1

Elasticity, a measure of how much buyers and sellers respond to changes in market conditions, allows us to analyse supply and demand with greater precision.

The law of demand states that a fall in the price of a good raises the quantity demanded. The price elasticity of demand measures how much the quantity demanded responds to a change in price. Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price.

We can state some general rules about what determines the price elasticity of demand:

• Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others.
• Necessities tend to have inelastic demands, whereas luxuries have elastic demands
• The elasticity of demand in any market depends on how we draw the boundaries of the market. Narrowly defined markets tend to have more elastic demand than broadly defined markets, because it is easier to find close substitutes of narrowly defined goods.
• Goods tend to have more elastic demand over longer time horizons.

Because the quantity demanded of a good is negatively related to its price, the percentage change in quantity will always have the opposite sign to the percentage change in price. A larger price elasticity implies a greater responsiveness of quantity demanded to price.

• When demand is inelastic (price elasticity less than 1), price and total revenue move in the same direction
• When demand is inelastic (price elasticity greater than 1) price and total revenue move in opposite directions.
• If demand is unit elastic (price elasticity exactly equal to 1) total revenue remains constant when the price changes.

In addition to the price elasticity of demand, economists also use other elasticities to describe the behavior of buyers in a market. The income elasticity of demand measures how the quantity demanded changes as consumers’ income changes

Necessities tend to have small income elasticities. Luxuries tend to have a large income elasticities.

The cross-price elasticity of demand measures how the quantity demanded of one good changes as the price of another good changes.

The price elasticity of supply measures how much the quantity supplied responds to changes in the price. Supply of a good is said to be elastic if the quantity supplied responds substantially to changes in the price. Supply is said to be inelastic if the quantity supplied responds only slightly to changes in the price.